Risk Management

GEA Group Aktiengesellschaft has grown considerably in recent years. However, sustainable growth can only be achieved if both the opportunities and the risks associated with business activities are identified and adequately taken into account. For this reason, an effective control and risk management system represents one of the core elements of corporate governance at GEA Group Aktiengesellschaft.

Risk and opportunity management targets

GEA Group’s ability to leverage its growth and earnings potential depends on it using the opportunities that arise, although this in turn is associated as a matter of principle with business risks. Taking calculated risks is therefore part of GEA Group’s corporate strategy. To meet the objective of sustainably increasing enterprise value, it is necessary, as far as possible, to enter into only those risks that are calculable and matched by greater opportunities. This requires active risk and opportunity management, which avoids inappropriate risks, monitors and manages risks entered into, and ensures that opportunities are identified and utilized in good time. GEA Group’s strategic and medium-term planning are key components of the way in which it manages opportunities and risks. These processes are used to prepare decisions on core technologies and markets, along with the corresponding allocation of resources. The objective is to ensure stability by diversifying and by concentrating on markets of the future. At the same time, developments that may jeopardize GEA Group’s continuing existence can be identified at an early stage. Opportunities and risks arising from significant operating decisions – for example whether to take on orders or to implement capital expenditure projects – are assessed and hence actively managed by the relevant departments and decision-makers at all group levels in a decision-making process that takes materiality criteria into account.

The basic principles of an orderly risk management system and the related workflows are documented in group-wide risk guidelines, which are broken down and structured in greater detail regularly by the segments to meet their specific requirements. These guidelines also document mandatory risk reporting and management requirements. Compliance with these requirements is monitored regularly by the Internal Audit function.

Risk management instruments such as the Risk Assessment and Advisory Committees (RAACs) are supplemented by a reporting system encompassing evaluated risk reports, consolidated financial projections, monthly consolidated financial statements, and regular meetings between the Executive Board and the segment heads to enable the various risks to be identified and analyzed.

GEA Group’s risk management system is based on the management hierarchy. Risks are reported to the next highest management level using predefined thresholds.

The specific requirements of the group’s project business are addressed by risk boards at segment and group management level. Before a binding quotation is submitted or an agreement signed, the commercial and contractual terms of potential orders are examined in detail by specialists from various departments so that risks that cannot be controlled are avoided. The risk management system therefore already comes into play before risks arise, in the form of a critical examination of the opportunity and risk profile of quotations. No agreement may be signed if the profile is inappropriate.

The risk management system is not only designed to identify risks that endanger the group’s continued existence at an early stage, as required by law; it also captures all risks that might have a material adverse effect on the operating result of a segment or the group. Additional modules were added to GEA Group’s risk management system in fiscal year 2013 in order to systematically capture risks and opportunities not covered by the existing systems; these make it possible to assess risk on a holistic basis.

Information is gathered and consolidated in an iterative process across all organizational units in a “Risk & Chance Scorecard.” To identify risks that could endanger the continued existence of GEA Group as a going concern, all issues are assessed for their financial materiality (on a gross basis, i.e. excluding any risk-mitigating measures) and their probability of occurrence. In addition, the timing (less than or more than one year) of each risk is individually assessed.

The following criteria are used to determine materiality:

Risks and Opportunities

Probabilty

<40%

40-60%

>60%

Insignificant

Low

Low

Middle

Moderate

Low

Middle

High

Considerable

Middle

High

High

Insignificant - Impact on financial and earnings position between EUR 0.25 - 2.5 million
Moderate - Impact on financial and earnings position between EUR 2.5 - 10 million
Considerable - Impact on financial and earnings position > EUR 10 million

This makes it possible to classify both risks and opportunities in accordance with their impact on GEA Group. Issues with short-term relevance that have a high (“H”) materiality and probability rating are initially classified as a significant risk or significant opportunity.

In addition, the GEA Demand Index (GDI) is used to collate estimates by GEA Group’s market experts of expected short- to medium-term market developments. The GDI makes it possible to obtain an early indication of positive or negative market developments in the industries and regions that are relevant for GEA Group.

The data gathered using the Risk & Chance Scorecard and the GDI is processed along with other internal and external information in a scenario and sensitivity analysis, which simulates the potential impact on the group’s liquidity).

Adequate provisions have been recognized for all identifiable risks arising from the group’s operating activities provided that the recognition criteria for liabilities have been met. The following section provides details of existing risks. Risks that are not yet known or currently regarded as insignificant may also have an adverse effect on business activities.

GEA Group’s internal control system (ICS) is based on the COSO framework and comprises the risk management system (RMS) as well as other principles, measures, and rules (other components of the ICS). While the RMS aims at identifying and classifying risks, the components comprising the rest of the ICS serve primarily to prevent or mitigate risk using control measures. The Internal Audit function is another component of the ICS.

The RMS comprises principles, measures, and rules relating to the early risk recognition system in accordance with section 91(2) of the Aktiengesetz (AktG – German Stock Corporation Act) as well as those relating to other components of the risk management system. In the other components of the ICS, a distinction is made between principles, measures, and rules that are related or unrelated to financial reporting.

GEA Group’s ICS relevant for financial reporting encompasses all principles, measures, and rules that ensure the proper approval and recording of business transactions for monthly, quarterly, and annual financial statements. The goal of the implemented ICS is to ensure reliable financial reporting, compliance with the relevant laws and standards, and the cost-effectiveness of business workflows.

In addition to GEA Group Aktiengesellschaft, all group companies are integrated into the ICS.

The following key principles of GEA Group’s ICS must be applied in all business functions: clearly defined areas of responsibility, the separation of functions in all areas of activity, dual signature policies, compliance with guidelines, instructions, and procedural requirements (manuals), the obligation to obtain comparative offers before awarding contracts, protection of data from unauthorized access, and the holding of training sessions to ensure uniform procedures within the group.

Key measures and rules that are relevant for financial reporting and are designed to ensure uniform accounting at all subsidiaries are: accounting and account allocation manuals, a uniform chart of accounts, consolidation and calculation manuals, the approval of entries using the dual control principle, and the fact that certain entries can only be made by selected persons. To prevent errors, standardized IT systems are used in GEA Group’s accounting, financial control, and finance functions in all group companies. All guidelines and IT systems are updated on a continuous basis to reflect legal
and business requirements.

Compliance with the principles, measures, and rules set out in the ICS as described above is monitored systematically; this takes the form of regular reviews by GEA Group’s Internal Audit function, which reports directly to the Executive Board and regularly submits reports to the Audit Committee. The results enable the elimination of defects identified at the companies reviewed and the ongoing enhancement of the ICS in the group.

Overall, the ICS aims to ensure the early identification, assessment, and management of those risks and opportunities that could materially influence the Company’s ability to achieve its strategic, operating, financial, and compliance-related objectives.

The performance risks presented below can take a wide variety of forms. The elements of the GEA risk management system are designed to help identify emerging risks before they materialize, so that appropriate measures can be implemented on a case-by-case basis to avoid negative effects on the group’s financial position and results of operations. As a rule, potential business performance risks are minimized by avoiding significant dependencies and ensuring a balanced mix of fixed and flexible capacities. GEA Group’s sales markets have a diverse product and customer structure. This diversification moderates the impact on total demand of fluctuations in demand in specific submarkets. However, the food industry is the main focus of the business. A significant decline in demand for food and beverages would have a material impact on GEA’s financial position and results of operations. GEA considers the probability of a global decline in demand to be low. This risk is rated as medium overall.

A significant proportion of GEA’s business consists of projects that depend on the financing available to GEA’s customers. A general decline in demand, shifts in currency parities, or a credit squeeze could make it more difficult to implement such projects. For the same reason, existing orders could be deferred or even canceled. If such risks were to occur on a global level, they would have a material impact on GEA’s financial position and results of operations. The probability of such risks occurring globally is considered to be low. This risk is classified as medium overall due to GEA’s diversified positioning in particular. Although country-specific conflict situations that may result in risks to the group are monitored continuously as part of the risk management process, the potential risks arising from such situations are difficult to quantify. However, no material impact on the group’s results of operations is anticipated. This risk is rated as medium overall. On the sales side, future prices will depend to a considerable extent on general economic trends. Any fall in capacity utilization in the industry could also have a significant negative impact on price levels and therefore on the financial position and results of operations of GEA Group. Thanks to the group’s regional and industrial diversification, the probability of such a risk is considered to be low. This issue is rated as a medium risk overall. GEA Group processes a number of materials, such as stainless steel, copper, and aluminum. Purchase prices for these metals may fluctuate significantly depending on market conditions. Long-term supply agreements are entered into with selected suppliers in order to lock in the procurement prices used as the basis for costing orders. However, the potential risks arising from such situations are difficult to quantify. With respect to procurement, current expectations are that prices for key materials will not increase. This risk is rated as medium overall. Long-term engineering orders are a significant element of GEA Group’s business. Some of these contracts entail particular risks, as they involve assuming a significant portion of the risk associated with the project’s completion. In addition, they may provide for warranty obligations that remain in force for several years after the project’s acceptance. Technical problems, quality problems at subcontractors, and missed deadlines may lead to cost overruns. There is therefore an extensive risk management system in place at group management and segment level to closely monitor order-related risks. This comes into play before binding quotations are submitted. Adequate provisions have been recognized for all foreseeable risks in this area. This could give rise to both risks and opportunities in relation to the financial position and results of operations. As a whole, this issue is rated as a medium risk. GEA’s business processes are highly dependent on information technology. The failure or malfunction of critical systems could result in risks relating to confidentiality, availability, and integrity, and key business processes could be compromised. GEA protects its IT systems against unauthorized access to the extent that this is economically feasible. The relevant security systems are updated on an ongoing basis.

Furthermore, the Company sees risks in connection with macroeconomic trends. If a downturn in the economy leads to a reduction in order intake to below the level of the previous fiscal year, this could have a negative impact on earnings due to capacity underutilization and capacity adjustment measures. Thanks to the group’s regional and industry diversification, and the fact that it is structured for flexibility, the probability of this significant risk occurring is considered to be low. This issue is classified as a medium risk overall. As contractually agreed, defined risks relating to selected orders remained with the group following the sale of the former Lurgi and Lentjes divisions. The guarantee period for most of these Lentjes orders has already expired. The other orders have provisionally been handed over to the customers and are therefore under warranty. Under the final agreement entered into with the purchaser of Lurgi, the risks arising from the selected Lurgi orders have largely been eliminated for GEA Group. The remaining risks are rated as low overall. The sale of the GEA Heat Exchangers Segment resulted in risks in the form of financial obligations towards the purchaser. These relate to contractual warranties and indemnifications, as well as risk sharing for major projects. This issue is assessed as a medium risk overall, with a low probability of occurrence. Dedicated and qualified employees are a critical success factor for GEA Group. The group has various staff policy measures in place to counter the risk that it will be unable to fill vacant positions adequately or that it will lose skilled employees. The measures aim to position GEA as an attractive employer and foster employees’ long-term loyalty to the group. The probability of this significant risk occurring is considered to be low. This issue is rated as a medium risk overall.

Acquisitions and internal company reorganizations entail risks resulting from the integration of employees, processes, technologies, and products. It is possible, therefore, that the aims of the measures in question will not be achieved at all or within the timeframe envisaged. Moreover, such transactions may give rise to substantial administrative and other expenses. Portfolio measures may also result in the need for additional finance and may impact negatively on financing requirements and the financing structure. These risks are countered by a structured integration concept and close supervision by internal experts, as well as specific training measures.

Several properties in our portfolio entail risks relating to environmental contamination and mining damage, primarily as a result of earlier business activities. These risks are countered through appropriate measures and supervision by internal and external specialists. Adequate provisions were recognized for the measures in 2014, as in past years. This could give rise to both risks and opportunities in relation to the financial position and results of operations. Their probability is regarded as medium and their materiality as moderate.

Principles of financial risk management
The Executive Board has put in place an effective set of guidelines to manage and hence largely limit or hedge financial risks throughout the group. The objectives with regard to protecting assets, eliminating gaps in security, and improving efficiency in identifying and analyzing risks are clearly defined, as are the relevant organizational structures, powers, and responsibilities. The guidelines are based on the principles of system security, the separation of functions, transparency, and immediate documentation.

Because it operates worldwide, GEA Group is exposed to currency, interest rate, commodity price, credit, and liquidity risk in the course of its ordinary activities. Financial risk management aims to reduce this risk through the appropriate use of derivative and non-derivative hedging instruments. The group’s financial risks are quantified in section 3 of the notes to the consolidated financial statements.

Based on a gross assessment, the financial risks described below are considered in principle to be both considerable and probable for GEA. These risks are therefore rated as high overall.

Currency risk
Because GEA Group operates internationally, its cash flows are denominated not only in euros, but also in a number of other currencies, particularly U.S. dollars. Hedging the resulting currency risk is a key element of risk management. The uniform group guidelines for central currency management used within GEA Group require all group companies to hedge foreign currency items as they arise in order to fix prices on the basis of hedging rates. Currency risks are hedged for recognized hedged items, unrecognized firm commitments, and highly probable forecast transactions. The hedging periods are determined by the maturity of the hedged items and are usually up to 12 months, but in exceptional cases may exceed that period significantly. Nevertheless, changes in exchange rates may affect sales opportunities outside the eurozone. Affiliated group companies based in the eurozone are obliged to tender to GEA Group’s central finance unit all outstanding exposures relating to transactions in goods and services in major transaction currencies. Most of these exposures are passed on directly to banks at matching maturities, depending on the hedging objective of the derivatives and the related accounting treatment; they may also be hedged as part of a portfolio. The hedging of financial transactions and transactions conducted by subsidiaries outside the eurozone is also closely coordinated with the central finance unit.

Interest rate risk
Because GEA Group operates worldwide, liquidity is raised and invested in the international money and capital markets in different currencies (but mainly in euros) and at different maturities. The resulting financial liabilities and investments are exposed to interest rate risk, which must be assessed and managed by central interest rate management. Derivative financial instruments may be used on a case-by-case basis to hedge interest rate risk and reduce the interest rate volatility and financing costs of the hedged items. Only the central finance unit is permitted to enter into such interest rate hedges.

Credit risk
Financial instruments are exposed to credit risk in that the other party to the contract may fail to fulfil its obligations. The counterparty limit system used by GEA Group’s central finance unit aims to continuously assess and manage counterparty default risk. A maximum risk limit has been defined for each counterparty, which in most cases is derived from the ratings from recognized credit rating agencies and credit default swaps (CDSs). Appropriate action is taken if the individual limit is exceeded. The financial standing of potential customers is ascertained before orders are accepted using an internal risk board procedure. Active receivables management, including non-recourse factoring, non-recourse financing, and credit insurance, is also performed. In the case of export transactions, confirmed and unconfirmed letters of credit are used alongside sureties, guarantees, and cover notes, including from export credit agencies such as Euler Hermes. In addition to local monitoring by the subsidiary in question, GEA Group oversees the main credit risks at group management level so that any accumulation of risk can be better managed. Since trade receivables are usually due from a large number of customers in different sectors and regions, there is no concentration of risk. Valuation allowances take account of specific credit risks. So as to reduce the credit risk involved, derivative financial instruments are only entered into with reputable financial institutions whose creditworthiness has been classified as reliable under the counterparty limit system described above; this is also continuously monitored. The maximum exposure for the financial assets is limited to their carrying amount.

Liquidity risk
GEA Group is exposed to liquidity risk in that it may be unable to meet payment obligations because it has insufficient cash funds at its disposal. The central finance unit is responsible for managing this risk. Cash funds are arranged and credit lines managed on the basis of a multi-year financial plan and a rolling month-by-month cash forecast. The funds are then made available to the companies by group management. Cash pools have been established in a growing number of countries in order to optimize the use of cash funds and borrowing within GEA Group. To mitigate liquidity risk, GEA Group will continue to use various financing instruments in the future so as to diversify its sources of funding and stagger maturities. The impact of potential risk scenarios on changes in liquidity is simulated on a quarterly basis. All internal risk management information and internal and external information on potential market and other external risks is taken into account. On the basis of this, the Executive Board and Supervisory Board have agreed strict rules regarding the level of cash and long-term credit lines to be held to cover potential liquidity risk.

Tax Risks
The applicable national tax legislation may affect the use of loss carry-forwards and thus the recoverability of the deferred taxes recognized in the consolidated financial statements and current taxation. Furthermore, future changes to the ownership structure could significantly reduce or even render impossible the use of German loss carry-forwards (section 8c of the Körperschaftsteuergesetz (KStG – German Corporate Income Tax Act)). The ability to use U.S. loss carry-forwards could also be restricted in the case of certain changes to the ownership structure of GEA Group Aktiengesellschaft under IRC section 382 (limitation on net operating loss carry-forwards following an ownership change). Moreover, in Germany and abroad, there is considerable uncertainty regarding future changes to, and the application of, tax legislation as a result of tighter public sector finances, the resulting pressure for reform, and tangibly greater scrutiny by the tax authorities. The tax risks presented could have a material effect on GEA’s financial position and results of operations. The occurrence of material negative effects is considered to be relatively unlikely.